Woodstock Quarterly Newsletter / Q2 2019
The behavior of equity markets in the first quarter of 2019 was nearly the mirror image of the fourth quarter of 2018. Global equities rallied strongly with U.S. stocks leading the way, reversing the sharp U.S.-led downturn in the fourth quarter. After falling by -13.52% in the fourth quarter of last year and by -4.38% for all of 2018 including dividends, the Standard & Poor’s 500 Index returned +13.65% in the first quarter of 2019, its best quarterly return in ten years. The S&P 500 ended the quarter just 3.3% shy of its all-time closing high established on September 20, 2018.
While concerns around slowing global economic growth, reduced corporate earnings expectations, and political uncertainties persisted, equity markets moved higher.
Much of the rally in U.S. stocks has been attributed to a significant shift in Federal Reserve strategy away from its monetary tightening bias and renewed optimism around a U.S – China trade deal. Mostly positive U.S. economic data points, along with solid reported fourth quarter 2018 corporate earnings, provided additional fuel to the rally. For the quarter, all eleven S&P 500 sectors posted positive gains, with seven of the eleven sectors advancing in price by double-digit percentages. The first quarter’s rebound in U.S. stocks was widespread with stocks of both small and mid-capitalization stocks, as measured by the Russell 2000 Small Cap Index and S&P 400 Mid Cap Index respectively, modestly outperforming the S&P 500 large company index. International stock markets rebounded strongly but still underperformed U.S. stocks (see Market Barometers table below for details).
The monetary policy environment for equities improved considerably in the quarter, providing a powerful tailwind to investor sentiment, as major central banks backed away from pursuing tighter monetary policy. After raising the federal funds interest rate in mid-December by another 25 basis points, the fourth such rate hike in 2018 and the ninth hike since this rate cycle began in 2015, the late 2018 market downturn and signs of slowing global economic growth spurred the Fed to communicate an indefinite pause in its rate tightening. Following its March meeting, the Fed indicated there would likely be no interest rate hikes in 2019 and perhaps only one in 2020. This was a significant about-face in monetary policy and a shift from the Fed’s previous forecast in December. Market expectations switched from anticipating several more rate hikes in 2019 to no hikes, with some market participants and Fed futures even suggesting a rate cut in 2019. National Economic Council Director Larry Kudlow said the Fed should even lower its benchmark federal funds rate by 50 basis points to help protect the U.S. economy. The Fed also announced that it would stop shrinking its balance sheet later this year, leaving its bond holdings at a higher level than previously anticipated.
For bonds, concerns regarding the strength of the economy, modest inflation and the Fed’s shift from hawkish to dovish fueled a decline in yields. The yield on the benchmark 10-year U.S. Treasury note started the year at 2.69%, hit a 15-month low of 2.39% in March and ended the quarter at 2.41%. Bond yields and prices move in opposite directions.
Driving the policy shift was the downside to the economic outlook—continued signs of a moderation in U.S. economic growth and a much sharper slowdown overseas. At their March post-meeting press conference, Federal Reserve Chairman Jerome Powell indicated that the policy revision was a result of a changing economic backdrop. He acknowledged that growth in U.S. consumer and business spending had slowed in recent months and pointed to a more pronounced slowdown in European economies. Likely concerns about December’s stock market drop, the 35-day U.S. Federal government partial closure, and trade negotiations with China also had a part in influencing the Fed’s pivot. Chairman Powell stressed a much more patient approach to monetary policy reasoning that with core inflation failing to threaten the central bank’s 2% target, the Federal Open Market Committee can be patient and wait to see how the economy evolves in the coming months.
The Fed was not the only central bank to shift to more accommodative monetary policy. Notably, in a major policy reversal, the European Central Bank (ECB) altered its forward guidance at its March meeting, stating that rates would remain unchanged at least through the end of 2019 and it said that it will start its third program to stimulate bank lending to counter a softening economy. The dovish announcements came as the bank lowered its 2019 European growth forecast to 1.1% from 1.7%. China’s economy continued to slow, pushing authorities toward more policy stimulus which should provide support to both China and the global economy in the coming months.
The same signs of slowing economic growth that led the Fed and the ECB to take their feet off the brakes were accompanied by a signal from the U.S. bond market that the likelihood of a recession is increasing. In March, amid signs of a moderating U.S. economy, some portions of the Treasury yield curve inverted, as yields on bonds with shorter maturities declined less than yields offered by longer maturities. The 3 months – 10-year Treasury yield spread inverted for the first time since 2007. An inverted yield curve has historically been one of the most accurate predictors of a recession, though the lead time from the inversion has varied significantly and has tended to signal onset of a recession by a year or more.
At this juncture, global economic growth remains positive although it has become more uneven and many major economies have progressed toward more advanced stages of the business cycle. The economic growth rate of many European countries has slowed to one percent or less and Italy’s economy is already in recession. The U.S. economy appears stronger than the economies of many developed countries and is decisively in late-cycle but with low near-term risk of recession. U.S. economic growth is expected to slow in 2019 but remain healthy with real Gross Domestic Product (GDP) expected to grow closer to 2% in 2019, down from 2.9% last year.
Corporate earnings growth is expected to slow but remain positive in 2019. Fourth quarter 2018 earnings for S&P 500 companies grew +13.4% year-over-year, making it the fifth consecutive quarter of double-digit year-over-year growth. Earnings growth is expected to decelerate sharply in 2019 to single digit territory as year-over-year comparisons become more challenging in light of the tax cut–related boost to corporate earnings in 2018. Continued U.S. dollar strength and the impact of trade tariffs could be additional headwinds for earnings.
The U.S. equity bull market marked its tenth anniversary on March 9, 2019 (subject to a new closing high) and the S&P 500 was up 319% over the 10-year period (+15.32% annualized) and up 417% with dividends reinvested (+17.76% annualized). Increased market volatility and significant gyrations in quarterly market returns are indicative of a late market cycle.
Given our expectations for moderating, yet still healthy U.S. economic growth and corporate earnings growth, the environment should be conducive to gains in equity prices, but downside risks are growing as we approach the end of the economic cycle. A recession is likely many months away. However, equities may remain volatile, and we may see periods of both strength and weakness in 2019. After such a significant price advance in equities in the first quarter, we are mindful of several potential market risks going forward. These include: any reversal in the view that the Fed will not raise interest rates this year (driven by stronger than expected economic data), outcomes of U.S.– China trade negotiations, Brexit, difficult year-over-year earnings growth comparisons, and political uncertainties as we enter the U.S. Presidential election cycle. We continue to believe equities of well-managed companies with strong financial characteristics and sustainable competitive advantages, with holdings diversified across most S&P 500 economic sectors, are the right posturing in the environment we anticipate. Equity selection will be particularly critical and our active investment management strategy should have an opportunity to continue to shine in 2019. We recommend maintaining appropriate levels of cash and short-term bonds for clients who draw upon their accounts. As always, we remain focused on investing for the long-term.
Maureen J. Murphy
Vice President and Portfolio Manager